When UK electrical retailer Comet collapsed into administration last November, anger was directed at turnaround group OpCapita over the structure of its investment.

Comet’s fall: OpCapita came in for criticism over the structure of its deal

The group was widely criticised for providing little investment outside offering a £30m credit facility – which, according to two people with knowledge of the deal was barely used – while standing to receive about £50m from the sale of Comet’s assets, given its status as a secured creditor.

Unlike a traditional buyout, where a sponsor would be expected to provide a meaningful amount of equity, turnaround deals are often structured to include a debt element, which provides the acquirer with a higher degree of security, should the business continue to struggle.

According to Will Wright, a managing director at financial advisory firm KPMG, the nature of the investment will depend on several factors beyond risk, including the size of the company being acquired.
Wright said: “We work with about 70 turnaround specialists across Europe, and, as with any sample that size, you have a range of appetites to risk. But if a group can transact taking a debt risk over a short period, rather than an equity risk, they will aim to do that.

“The larger end of the market – for example Better Capital and Sun European – is more inclined to put equity on the table but in a number of cases competitive tension will influence the structure of any investment,” he said.

Wright said it was important to distinguish between acquisitions that are made while a business is in distress and those that occur after a business has been put into administration, which carried an "insolvency stigma".

Security required

Any assets purchased by the turnaround firm from the administrator can be used as security against its investment, which usually takes the form of a credit facility to provide working capital until the business improves.

But Adrian Doble, head of restructuring at FRP Advisory, said: “Funding a phoenix [taking a firm out of administration] is a risky strategy”.

He added: “Customers may drift away to competitor businesses, particularly in the manufacturing sector, where buyers want certainty of supply or if the new company refuses to honour warranty claims on the old business.

Industry sources said suppliers, which have lost money, often raise their prices or insist on payment up front. Credit insurers can suspend cover, and reputation can be irrecoverable.

Doble said: “So, while any incoming capital is usually structured as a loan, which will be secured by debenture over the new company, most [deals] require high-risk equity to survive.”

As a result of these difficulties, advisers are increasingly urging company managements to begin a sales process before the financial situation becomes acute. But despite this proactive approach of advisers, deal completion rates remain low.

Jamie Constable, chief executive and co-founder of turnaround firm RCapital, said stubborn management was to blame in many of these situations. He said: “Despite being in a difficult position, many business owners are often unwilling to accept turnaround capital investment. It’s not unusual for them to want to receive credit on bank terms at about 3% when a more sensible risk-adjusted return is between 7% and 20%.

“Businesses need capital like cars need petrol, and capital is very much in short supply. Every business we are looking at is in a stressed situation, be it with banks, HMRC [HM Revenue & Customs] or suppliers. For the moment, many of them are able to plod along as demand for their products and services is subdued. But when the market improves, cash constraints will become more acute and many are likely to fail.”

Constable described a recent situation where a business owner rejected an investment offer because he felt the terms – a secured loan at 12% alongside an equity stake in the business – were too high a price to pay.

Constable said the business fell into administration after rejecting the terms: “There is a perception that debt is cheap because the base rate is low. But the reality is that a risk-adjusted return is far higher.
“Once a business reaches the distressed stage it becomes much more challenging to invest because customers are making other arrangements, staff are likely to be poached by rivals and both goodwill and credit will be in short supply,” he said.

Collapse and purchase

Collapsed businesses are rescued in two ways: A restructuring firm moves in to buy the assets – as Hilco did with music and DVD retailer HMV – or the sale of the assets is agreed in advance of formal administration and the deal completes once the company enters insolvency.

Doble cites Better Capital’s acquisition of fashion chain Jaeger in April last year as an example of a successful pre-pack administration: “Better Capital is one investor that has successfully used the pre-packaged insolvency process to effect a change of control and the clothing brand Jaeger is a good example of a turnaround that should be successful. Retail customers are rarely concerned with the stigma of insolvency as their loyalty is to the brand.

“Where the customer is remote from the business – and a retailer is a good example – insolvency buyouts should have a greater degree of success. In cases where the business is part of a supply chain such as in manufacturing the chance of rebuilding is lower.”

High-street turnaround

RCapital’s Constable said: “We expect there to be increased dealflow in the coming months as banks look to manage underperforming loans and equity stakes off their books.

“The general attitude has changed from hoping for a rebound in the economy to accepting that low-level growth is a reality and there will be more value to be had in moving businesses off their books,” he said.
Buyout experts say lenders appear to be more willing to write off their UK assets than in previous years.

They say nowhere is this more apparent than on the high street, where retailers Jessops, HMV, UK hotels group QHotels and clothing chain Republic, have all entered administration. Of these businesses only Republic was backed by private equity and majority-owned by US buyout firm TPG. According to one turnaround investor, the performance of Republic is understood to have dramatically worsened last month with like-for-like sales “dissolving faster than I’ve ever seen before”.

Another said: “When the situation changes so quickly you don’t know what went wrong, that makes it impossible to know how to fix.”

TPG is set to lose most of its £150m equity investment, according to one person close to the situation, having owned the business since a £300m buyout in June 2010.

TPG declined to comment.

--This article first appeared in the print edition of Financial News dated February 25, 2013